What’s wrong with LIBOR?
Concerns about LIBOR have existed since the stressed market conditions of 2007 and 2008. However, LIBOR came to international attention in 2012 when it came to light that LIBOR had been manipulated by certain Panel Banks. This prompted the Government to launch the Wheatley Review in November 2012.
Whilst the Wheatley Review focused on the short-term reform of LIBOR and only tentatively explored the case for LIBOR’s replacement (and therefore the use of alternative benchmarks) it did raise some of the main issues with LIBOR which have come to the fore today.
LIBOR operates on the assumption of a permanent and deep unsecured interbank market
This assumption has been significantly weakened as the amount of activity in the interbank market has diminished over time for various reasons, including:
- Since the financial crisis, few participants wish to lend on an unsecured basis, particularly on a term longer than overnight (e.g. 3 month)
- Liquidity in the interbank market has generally dwindled since the 1990s and disappeared completely during the crisis demonstrating that in stress conditions the assumption underpinning LIBOR was little more than theoretical
- Short term wholesale debt attracts more regulatory capital than other types of debt and so banks have moved away from the market
“Manipulation can be prevented, but liquidity cannot be invented“
(ICMA, Repo FAQs)
“[LIBOR] is in many ways the rate at which banks do not lend to each other […] it is not a rate at which anyone is actually borrowing.“
Mervyn King, former Governor of the Bank of England
The migration of liquidity away from unsecured interbank markets has had other consequences:
- Banks have been increasingly reluctant to submit quotes on the basis of an inactive market with the attendant risk of exposure to litigation, indeed some banks have stopped submitting
- The price discovery process and fundamental credibility of LIBOR as a benchmark has been further impacted
“The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets. If an active market does not exist, how can even the best run benchmark measure it?
Moreover, panel banks feel understandable discomfort about providing submissions based on judgements with so little actual borrowing activity against which to validate those judgements.“
Andrew Bailey, Chief Executive of the FCA
If not LIBOR then what?
In addition to the Wheatley review in the wake of the LIBOR manipulation scandal, the Financial Stability Board (“FSB”) (which is an international body that monitors and makes recommendations about the global financial system) undertook its review of interest rate benchmarks (LIBOR, EURIBOR and TIBOR) and in 2014 published its report on reforming major interest rate benchmarks (the “FSB Report”).
The FSB Report recommended that the financial markets should identify and use risk-free rates or nearly risk-free rates (“RFRs”). RFRs are perceived as more reliable because they are based on market transaction data and do not require judgment-based submissions.
“The cases of attempted market manipulation and false reporting of global reference rates, together with the post-crisis decline in liquidity in interbank unsecured deposit markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates”
Subsequent to the above, the FCA has issued ever more pointed statements to the effect that market participants should wean themselves off of IBORs and adopt RFRs, beginning with its “Dear CEO” letter of September 2018 to large banks and insurers and culminating in its recent joint (with the BofE and the PRA) statement in January 2020 (i) setting out the FCA’s and PRA’s initial expectations of firms’ transition progress during 2020, including in relation to the targets set by the RFRWG and highlighting the close monitoring by the BoE’s Financial Policy Committee of the steps being taken by firms; and (ii) encouraging market makers to switch the convention for sterling interest rate swaps from LIBOR to SONIA This is designed to help progress transition in the derivatives market.
This latest statement from the FCA and Bank of England pertinently states that Banks have until September (end Q3) 2020 to stop issuing cash products linked to Sterling LIBOR and to switch to alternative rates sooner rather than later. The FCA wants to see clear engagement from firms and is “keeping the potential use of supervisory tools under review“, which may mean via senior managers regime and/or regulatory capital hikes.
The ECB has also weighed in asking:
– by COB 31 July 2019, for (i) a board-approved summary of each addressee institution’s assessment of key risks relating to benchmark reform; (ii) a detailed action plan to mitigate such risks, to address pricing issues and to implement process changes; and (iii) a list of contact points at management level who are in charge of oversight of such action plans; and
– by 15 September 2019, for a reply to a detailed questionnaire attached to its letter.
Concurrently, the FCA and others have started to focus on institutional conduct risk in the context of IBOR transition. The FCA’s webpage highlights risk in the following areas:
- governance and accountability;
- guidance on replacing LIBOR-linked products;
- treating customers fairly;
- guidance on offering new RFR-linked products;
- communications with customers on LIBOR transition; and
- guidance specifically targeted at asset managers on identifying exposures to LIBOR and engaging with issuers of LIBOR-linked products to which they are exposed.
AFME has also joined the debate with its publication in December 2019 of a white paper on conduct risk in the context of IBOR discontinuance.